Here’s something you probably don’t want to hear: the human brain isn’t wired right to help you make money on the stock market. The unfortunate truth is that the logic we use for our daily ‘economic’ decisions doesn’t work well in the stock market. If you recognise this in-built flaw, you can turn it to your advantage.
Here’s what I mean.
Forget about simple theories when it comes to investment
In everyday life, if the price of something goes down, we buy more of it; if something gets more expensive, we buy less. The price acts as a signal. So when petrol spikes up, we demand less of the stuff. We head for substitutes, like the bus, bike, or train. We may even car-share, or avoid a driving holiday. You get the idea.
But when it comes to investments, price signals just don’t work.
When the price of houses, stocks, commodities – anything that you can consider a long-term asset – goes up, then buyers flock to the things. Rising prices generate demand. Sounds bizarre doesn’t it?
Investors fill up their ISAs when stock prices are high. And when stocks are moving upwards, the analysts get bullish too. Everyone’s buying.
And guess what? When stocks go down and get cheap, everyone hates them. Just like the bottom of the market in early 2009 when the market traded on a P/E of 7x. Now we know that the long-run average for the market is a P/E of 14x, and if the market’s under 10x, it’s cheap. So why wasn’t everyone charging in when the market was trading at a P/E of 7x?
This phenomenon comes down to sentiment
Positive sentiment keeps investors coming back for more when a market is going up, while negative sentiment drives them away from cheap markets. It’s incredibly powerful. It’s not based on rational logic, but herd instinct.
Just look at the housing market during the early nineties bear market when sentiment was negative. Where were all the buy-to-let guys then? Only a few contrarian investors were building portfolios in those days and they made fortunes!
And here’s something else worth noting: sentiment is always at it’s height at market tops and bottoms. At the top of the last housing market, Northern Rock offered to lend 125% of the value of a property. The market could only go up, so why not lend in anticipation of higher prices?
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I’m not going to get ‘holier than thou’ about this irrational exuberance. On the contrary, we can harness it in two ways.
Momentum trading
This is a trader’s strategy that exploits herd instinct. Identify a rising market, then jump on for the ride. This is exactly the strategy that I identified for playing the gold bull market last week.
Here, I used the strategy to make the most of positive sentiment. But equally, if you’ve got a market that’s heading down, then you short it in exactly the same way.
I’d be careful with momentum trading though. I’m using it on gold because I’m a gold bull anyway. That’s what makes me confident in using sentiment to help push the trade in my direction.
Now, the text books say that you can just pick any stock or market and gamble on the trend continuation. This is too dangerous. If it were that easy, believe me, everyone would do it. As an investor you have to add value to the trade. For me that’s using some analysis to back your trade.
Bottom line – if you fundamentally believe in a trade, and sentiment is on your side, then let it to help you along. But beware when sentiment turns; you’ll need to unwind the trade quick.
Contrarian investing
This is a long-term strategy and one that I feel a lot more comfortable with. It teaches us precisely the opposite of momentum trading. Believe it or not, both strategies can be profitably employed, so long as you recognise when to use each one.
Contrarianism recognises herd behaviour and says that it’s a bad thing. If everyone is bidding up the price of something, then it must be getting too dear. And if something’s deeply unfashionable, it’s probably cheap.
Contrarianism is to do with long-term investing. In fact, it’s so long-term that most professional fund managers don’t use it. Most are focused on the short-term, as they’re measured against market indices each quarter.
Fund managers are unlikely to place long-term bets that run against market sentiment. They cannot cope with the stigma of not running with the crowd.
They’re missing a trick, and it’s one that we can capitalise on.
Profiting from herd instinct
The gold trade I outlined last week could turn out to be a fantastic momentum trade, but may be a little risky for you. If that’s the case, you’re more likely to profit from strategy two above.
When everyone else zigs, you zag!
• This article was first published in the free investment email
The Right Side
on 21 June 2010
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